The CFP Professional: At the Nexus of Debt & Wealth. The Innovative Scholar Inc. Patrick O Meara, CFP, CMA, MBA

Transcription

1 The CFP Professional: At the Nexus of Debt & Wealth The Innovative Scholar Inc. Patrick O Meara, CFP, CMA, MBA

2 The Life Cycle Hypothesis Household Formation Debts rise First time homebuyers Pay down student debt Purchase first car Middle Years Income rises Debts decline Near Retirement/Retirement Savings Drawing down on savings

3 The Concept of Permanent Income Present value of all expected future income.

4 The Concept of Permanent Income Why permanent income? Households want to maximize consumption Smoothing consumption out over their lifetime allow HH s to maximize the value of expected future income Consumption is stabilized or smoothed out over the life of the HH

5 Permanent Income & the Use of Credit The original balance of a loan is the present value of all future payments to be made by the borrower The difference between total payments & the PV of a loan is the forgone future consumption or savings the total interest cost of the loan Credit facilitates the intermediation of consumption & future HH income

6 Canadian Households and Debt Debt has become a national obsession: Canadians take up more debt Banks, credit unions, etc lend more Policy makers obsess over the consequences of more debt

7 The Rise in Canadian Household Debt 163% 80%

8 National GDSR vs TDSR 53.7% 24.5%

9 Lower Interest Rates Higher HH Incomes

10 Rising Real Estate Prices Financial Innovation

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12 9.00% Canadian Mortgage Rates % 7.00% Mortgage Rate 6.00% 5.00% 4.00% 3.00% 5 Yr. Mtg 1 Yr. Mtg 2.00% 1.00% 0.00%

13 House Prices

14 Mortgage Payment Affordability

15 Mortgage Payment Affordability

16 Rise in the Use of Lines of Credit: 1990 to % 2% DISPOSABLE INCOME

17 Rise in Traditional Mortgage Debt: 1990 to % 2.3% DISPOSABLE INCOME

18 Use of Equity Extracted Funds

19 Lines of Credit: Intertemporal Shifts in Assets to Debt By definition the use of home equity lines of credit is an intertemporal movement of items, in particular equity in fixed assets, such as, a consumer s principal or other real property, from the right hand side of the personal balance sheet (assets) to the left hand side of the personal balance sheet (liabilities).

20 Use of Equity Extracted Funds Households that have no financial constraints with regards to consumption, and a long-term expected tenure in their current home, tend to have little to no (zero) propensity to borrow-spend against home equity.

21 Use of Equity Extracted Funds Households that have an expected short-run tenure in their home, and are willing to use the equity in their home for consumption prior to their actuarial expiry have positive propensities to borrow against homeequity.

22 Use of Equity Extracted Funds Households whose consumption is financially constrained also have a positive propensity to borrow against equity.

23 Use of Equity Extracted Funds Households with recurring urge(s) for immediate consumption may aggressively borrow against their increased housing equity in order to finance consumption. Bailliu, J, et al, Household Borrowing and Spending in Canada, Bank of Canada Review , p. 23.

24 The Risks of Leveraged Consumption Since the 1980s housing prices have been consistently on the rise. Nationally, housing prices have risen by 88% on average since Varying from a 54% increase in the Atlantic region to a 130% rise in British Columbia. Peterson, B., et al, Medium-Term Fluctuations in Canadian Housing Prices, Bank of Canada Review, Winter , p. 31.

25 Fluctuations in Home Prices Historically housing prices have fluctuated by as much as plus or minus 30% of GDP in a 10 year or less period. This appears to be the result of slow changes in the supply of housing due to the nature of the development process in the construction industry. Peterson, B., et al, p. 33.

26 Fluctuations in Home Prices

27 The Effects of a Decline in the Market Value of Real Estate

28 The Psychology of Debt Current economic thinking would suggest that we are rational thinkers, and as such, our economic decisions are based on logic. A logic that is based on our actual place in time and our expectations of the future. This is NOT always the case, and research by finance specialists and psychologists provides us with insight into our ever-human foibles when it comes to borrowing and lending decisions.

29 The Psychology of Debt

30 The Psychology of Debt Present Value of $1.00 Hyperbolic & Exponential Models Time (Years) Exponential Discounted PV Hyperbolic Discounted PV

31 The Psychology of Debt

32 What Would Kenny Roger s Say? Does a gambler, having previously won $200 at the track, and subsequently losing $50, choose to account for his loss as a loss of $50 (100%) or as a loss of $50 of the $200 he previously won (25%)? Thaler, R., and Barberis, N., p

33 Perceptions of Wealth & Debt

34 Perceptions of Wealth & Debt When net worth is positive, debt contributes to negative perceptions of wealth, as measured by net worth. In other words, subjects are averse to debt when net worth is positive. When net worth is negative, assets appear to have a significant positive contribution to perceptions of wealth. In other words, people are drawn to weighting assets more heavily when net worth is negative.

35 Perceptions of Wealth & Debt Relative perceptions of wealth are dependent on: Relative weightings of debt and assets. Active accounts matter. Current income is more of a factor in people s financial behaviors. Net worth and its relative growth is NOT a factor in financial behaviours.

36 Which client do you perceive to be financially better off? Client A Client B Assets $8,000 $25,000 Debts $62,000 $79,000 Your Choice?

37 Which client do you perceive to be financially better off? Client C Client D Assets $75,000 $99,000 Debts $20,000 $44,000 Your Choice?

38 The Results of Our Experiments?

39 Questions?